With soaring liquidity comes inflation in asset prices and an impending asset bubble has already been formed, waiting to burst! The bubble, as we presume, is unlikely to burst throughout the country at the same time (since we have a genuine demand-supply gap); but in certain regional pockets, it has already started taking shape. The prime reason for inflation is surfeit liquidity and ever increasing interest rates on home loans. Inflation in February 2010 peaked at 9.89%, following a month of 8.56% inflation in January 2010. As per August figures, inflation was still at a high of 8.5%.

Inflation has remained high for an unreasonably elongated period, ensuring that the sizable middle class has seen its savings erode fast. At the same time, RBI has also increased its repo rate to 5% in FY 2010-11 from 4.75% in the corresponding period of 2009-10. And as a result of this, banks like SBI (the largest home loan providing bank), and most others et al have already started raising their home loan interest rates. While the RBI might succeed in demotivating new home buyers from taking loans, the past home buyers would slowly be pushed to the brink of defaulting, if not insolvency.

As per a recent study by CRISIL, the share of bad loans to total loans in banks, which was 2.3% in 2009 is likely to swell up to 4% in 2010; the same is further expected to rise to 5% in 2011. The final effect will be both economical (As per May, 2010 figures, total bank loans equalled Rs.305,325 crores) and psychological (as asset demand would crash).

The solution? Delink home loan rates from other base rates. Force banks to ensure that each home loan’s base rate remains at the original cost at which the bank procured the money (to then give it to the home loan customer). By arbitrarily increasing home loan rates across even old loans, banks are doing their mite to destabilise the economic situation. An RBI move is required right now.